Beta September 2015 version 10 MARKETS, CONTRACTS AND INFORMATION Courtesy of US Coastguard HOW ADAM SMITH’S “INVISIBLE HAND” MAY FAIL, AND HOW PRIVATE BARGAINING AND GOVERNMENT POLICY SOMETIMES IMPROVE THE OUTCOME • Governments provide essential conditions in which markets can exist and work well, including private property rights and enforcement of contracts • Market failures are Pareto-inefficient allocations in which potential mutual benefits from an exchange or other economic interaction are not realised, which will occur when markets are not competitive • Even when markets are competitive, market failures may occur if economic actors do not take full account of the effect of their actions on others • This will be the case when some aspect of an exchange (including effects on those not involved in it) is not covered by property rights and contracts that can be enforced • Costly environmental spillovers and the positive effects of knowledge creation by R&D are examples of external effects that are not fully covered in contracts • The reason is that the information necessary to enforce the necessary rights and contracts is not available to one or more of the parties • Private bargaining, government policy, or a combination of the two may improve a market allocation when there are external effects • For moral and political reasons some goods and services (for example our vital organs or our votes) are not traded on markets, but are allocated by other means See www.core-econ.org for the full interactive version of The Economy by The CORE Project. Guide yourself through key concepts with clickable figures, test your understanding with multiple choice questions, look up key terms in the glossary, read full mathematical derivations in the Leibniz supplements, watch economists explain their work in Economists in Action – and much more. 2 coreecon | Curriculum Open-access Resources in Economics Pick up any object in reach, and ask this thing a few questions: You Thing, who made you, and do I know your maker? Do you come from a place that I’ve ever been to? Where do the materials or parts that you’re made of come from? Maybe you picked up your phone, your cup or your mouse. Whatever you picked up, the thing’s answers (if things could talk) would be the same: Thing I was made by people you have not met, and will probably never meet, living in places you will probably never visit. You So how did you end up on my desk? Thing Long story. You are busy studying, so I’ll just give you a very short answer. You How short? Thing The market. Now imagine that the same questions had been asked of something anywhere in the world the year that Adam Smith wrote The Wealth of Nations. Many of the things that you might have picked up in 1776 would have been made by a member of the family, or of the village. Some would have been within reach because you had made the object yourself, some because you had use of them as a family member, and others would have been purchased from neighbours. One of the changes that was underway during Adam Smith’s life, but has greatly accelerated since, is specialisation in the production of the goods and services around us. As Smith explained, we become better at producing things when we each focus on a limited range of activities. The same is true of firms that often produce at lower unit cost by producing a large number of identical goods, as we have seen in Unit 7. But people will not specialise unless they have a way to acquire the other goods on which their livelihood depends. That is where the market comes in. Chapter 3 in Smith’s Wealth of Nations is called: “That the Division of Labour is Limited by the Extent of the Market”: “When the market is very small, no person can have any encouragement to dedicate himself entirely to one employment, for want of the power to exchange all that surplus part of the produce of his own labour, which is over and above his own consumption, for such parts of the produce of other men’s labour as he has occasion for.” — Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776) UNIT 10 | MARKETS, CONTRACTS AND INFORMATION 3 The market, alongside firms, as we saw in Unit 6, is what makes specialisation and the division of labour possible. And as the extent of markets expanded both globally and also to encompass goods and services that in the past were distributed within families, or as gifts, or not exchanged at all, specialisation and the division of labour has expanded with it. Today, the American retailer Walmart sells more than 4 million different products. When you think about markets, the word that often comes to mind is “competition”. But markets are also the foundation of the largest cooperative venture that our species has ever undertaken, in which billions of us engage, for the most part unwittingly, in providing the goods and services on which others live, gaining our livelihoods in return. The market does more than allow the extension of the division of labour. Markets are a way of governing an economy. In The Wealth of Nations, Adam Smith explained how the owners of capital (motivated by their individual desire for profit) and others (through their pursuit of a more comfortable or pleasant life) would make economic decisions that would benefit society as a whole. Capital would be invested where it was most productive, and the consumption of goods and services would economise on society’s scarce resources. He wrote that each individual could be: “[L]ed by an invisible hand to promote an end [the well-being of others] which was no part of his intention.” — Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776) In Unit 9, we examined Friedrich Hayek’s explanation of how Smith’s invisible hand could work. When it does, Hayek explained, prices send messages about the real scarcity of goods and services, messages that motivate people to produce, consume, invest, and innovate in ways that result in the best use being made of an economy’s productive potential. Hayek suggested we think of the market as a giant information- processing machine, providing information that guides the economy, usually in desirable directions. The remarkable thing about this massive computational device is that it’s not really a machine at all: nobody designed it; nobody is at the controls. When it works well we use phrases like “the magic of the market.” But sometimes the magic fails. In this unit we will ask how well the market works, and will consider cases in which prices send the wrong messages. Smith explained that in many areas, such as education and the legal system, government policies were needed to promote social wellbeing and to ensure that markets work well. Smith was also clear that that there were some things that should not be bought and sold on markets. The modern equivalents might include human kidneys, votes, a good school or life-saving medical care, and you might believe that some of these things should be allocated in some other way. 4 coreecon | Curriculum Open-access Resources in Economics For both Smith and Hayek, competition among many buyers and sellers is an essential part of the magic of the market and, when it is absent or limited, the invisible hand will not work. We examined the implications of competition in Units 7 and 8: • Firms facing little competition—monopolists or those producing differentiated goods—set their prices above marginal cost. • The price at which the good is sold then sends the wrong message: The high price overstates the real scarcity of the good as indicated by its marginal cost. • The resulting allocation is not Pareto efficient: Too little is sold, so there is a deadweight loss. • In contrast, firms in competitive markets are price-takers: They produce where price is equal to marginal cost, and the allocation maximises the total surplus of the buyers and sellers. For a market to work well (or even to exist) other social institutions and social norms are required. Governments, for example, provide a system of laws and law enforcement that allow markets to function effectively, by guaranteeing property rights and enforcing contracts. Social norms dictate that you respect the property rights of others, even when enforcement is unlikely or impossible. As we saw in Unit 1, if something is to be bought and sold then it must be possible to claim the right to own it. A purchase is simply a transfer of ownership rights from the seller to the buyer. You would hesitate to pay for something unless you believed that others would acknowledge (and if necessary protect) your right to keep it. And whenever you agree with a seller to pay a certain amount of money in exchange for a good—say a pair of shoes—you implicitly enter into a contract with the seller. If you have the protection of a legal system you can expect the contract to be honoured: when you get home and open the box the shoes will be there, and if they fall apart within days you will receive a refund. It is the government that determines the trading rules—the rules of the game in which market trade takes place. Of course enforcement by a court is rarely necessary because of social norms that motivate both buyers and sellers to play by the rules of the game, even in cases where there is not literally a contract or a transfer of a title of ownership.